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Securitization: The Good, the Bad, the Ugly

Jose D. Roncal www.financialspeculation.com

Jose D. Roncal

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www.financialspeculation.com

Before you read any farther, let’s start with a little background on the term securitization and how it’s evolved to the present times.  If you click the link toInsightful Articles and read the item entitled Wall Street’s Shadow Market, you’ll get a basic understanding of exactly what securitization means. It also points out how the misuse of securitization created the whole ugly economic mess we find ourselves in today.

There was a time when virtually all of the money lent to households originated with banks and other lending institutions. Lenders knew their borrowers and had ongoing dialogues with them, whether they were big companies or individual account holders. Just picture the scene from It’s a Wonderful Life to get a sense of this relationship.

But over the last five or six years more than half of the money loaned has come from the securitization market. Since financial institutions have the ability to originate loans, they also have the ability to package and sell those loans to others. So they began to take their assets, many of which were “toxic” home mortgages, and, through the securitization process, create what appeared to be attractive investment packages for pension funds and other types of institutional investors.

Securitization became a tool that very efficiently enabled the flow of capital from end investors back to the borrowers who genuinely needed the money. Ironically, it was the very success of the securitization products that caused investors to assume that these complex structures—which involved a plethora of players in different roles creating something no one really understood—were put together by credible, honest and diligent professionals.

The securitization process did work very well for the most part, until chaos ensued. The more murky things got, the more the system was abused and the more financial hardship was brought to investors and to the underlying financial institutions.  In fact, in this week’s news it was reported that more than 150 publicly traded U.S. lenders now own nonperforming loans that equal 5 percent or more of their holdings, a level that former regulators say can wipe out a bank’s equity and threaten its survival.

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The public had taken it for granted that all the players, the brokers, the investment houses, the lending institutions, regulators, and everyone involved in the process knew what they were doing, and more importantly, that each player knew what all the others were doing.  But clearly, that was not the case.  

Even the rating agencies played a role in the ruse, making profits by over-rating investments they knew had a high probability for failure. In the case of subprime debt, when it was discovered that billions of dollars were funneled into these rating agencies, it created a huge crack in the foundation of trust and Wall Street started to crumble.

Securitization in and of itself is not the problem; it was the abuse that created a great mistrust and stymied the markets. That’s why it’s so important for regulators to do whatever is necessary to restore credibility to the process so that investors will feel confident to begin investing again.

We have to recreate an environment where investors can evaluate the risk and have relative confidence that their analysis of the risk is consistent with the potential performance of the underlying investment. A responsible investment needs enough transparency to allow investors to evaluate the risk. Recently, however, investors have been misled.

Naturally, no investment is risk-free. If you read our bookThe Big Gamble, there can be no doubt left about that fact.

Meanwhile, how do we get the markets restored and money flowing again? We believe the markets can be recreated with a higher degree of discipline on the part of each of the players.  And that includes the regulators themselves who didn’t blow the whistle or notice the things that were going wrong.  Big change is called for, but let’s not throw securitization out of the process.

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The Solution – More Securitization

Even with the so-called TARP funds, there’s no possibility of the government, i.e. the tax payers, putting enough capital into banks to allow them to support the high demand for borrowing. What is needed is to restore the practice of securitizations in an honest forthright manner.

The role of government might best be served, not by providing more funds, but by taking the lead in designating a securitization structure that covers the full range of stakeholders in the process, one that provides more transparency and puts the investors’ interest out in front. We are not saying that Wall Street bonuses and incentives are bad; they are necessary.  But no more rewards for blatant manipulation and dishonesty.

There are three important elements that should be considered while recreating the markets: simplicity, transparency, and fairness. The final goal should be to allow borrowers to get credit on fair terms and to make it possible for investors to truly evaluate the inherent risks before investing.

If you found this article helpful, visit www.financialspeculation.com to claim your own copy of Jose Roncal’s popular FREE REPORT, “12 Keys to Smart Speculating in Tough Times.” It’s chock full of valuable insight on how to rebuild your nest egg. While you are there, check out “The Big Gamble: Are You Investing or Speculating?” See for yourself why Donald Trump has called it “a great read!”

About the author

José D. Roncal is a truly global executive with over 20 years of experience in international business and finance, having worked and travelled frequently in six continents.

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